> Mike Beggs wrote:
>
> It's possible for a dynamic to develop in which the size of
>> demand for financial assets exceeds rational borrowing by productive
>> units,
>> putting upward pressure on the valuation of financial instruments such
>> that
>> the valuations get out of touch with their real potential future fruition.
>>
>>
>
> Hmm. I think if you look closely enough at this scenario, it may turn out
> to be just another way of describing a recessionary shortfall in total
> spending. After all, savings deposits are financial assets too.
No this is definitely conceptually distinct. The 'upward pressure on the valuation of financial instruments' happens generally during the upswing. The reversal of valuation happens when certain assets lose value due to reassessment of their expected yield and/or liquidity. At that point a lot of people are holding assets for which they paid more than they are able to get upon sale - effectively their savings are devalued. It is at this point that there is an effect on expenditure on goods and services, via the reverse wealth effect and the increased cost of captal/borrowing.
You might argue that there is always some level of income-expenditure in the goods sector that would validate a given structure of expected yields on existing assets. That is true, but it is not necessarily a realistic level of income-expenditure. If asset prices have gotten out of line with income-expenditure (e.g., house valuations much higher than capitalised future rents given future supply and demand in the housing market, which depend ultimately on labour and capital incomes from the goods and services production) they eventually must come back into line through either asset price falls or goods price rises (i.e. inflation). (There are countervailing tendencies - house prices might permanently rise relative to incomes due to ability/willingness of households to sustain permanently higher debt:income ratios, or another bubble might begin before the last is fully worked out.)
I'm not sure what the point about savings deposits being financial assets is about. Sure I agree they are, but I don't get the relevance... maybe I am wildly missing your point!
Everything you say here is true - but you're burying the lede. You're right
> to say that the supply of financial assets, though not scarce in physical
> terms, is nevertheless bounded by expectations of future income streams. But
> then you go on to mention "fluctuations" in these expectations in a
> parenthetical way, as if these were merely a secondary, complicating factor.
> But the fluctuation of expectations is not secondary - it's the whole
> ballgame.
>
> The question that interests Fitch and Brenner and you and me is: What
> caused this crisis, and crises generally? The answer lies in these
> "fluctuations" (a term that doesn't really do justice to the phenomenon it
> describes). The point is, the future is unknowable. Therefore, agents must
> price financial assets on the basis of a lot of missing information. This,
> combined with human psychology, leads to periodic manias where people assign
> completely outlandish prices to assets, prices that imply completely
> outlandish streams of future income.
Where I differ from you is in not seeing expectations as 'the whole ballgame'. My point is that bubbles do not depend on manias alone. Demand for financial assets _as a whole_ is relatively interest-inelastic. This is Keynes's point in reversing the classical direction of causation between savings and investment - that saving is something people do to conserve purchasing power for the future, and because people want future purchasing power no matter what (for retirement if nothing else), the whole classical mechanism by which the interest rate adjusts based on some schedule relating present consumption to future consumption is bunk. Relative interest rates and liquidity preference (or more broadly, the rate of return on assets, including an implicit return from liquidity, safety) determine the allocation of savings between different assets. All I am saying is that there is a potential for new savings - which is an inflow of demand into the market for assets in general - may exceed the supply of new assets at going interest rates, which is based on an entirely different schedule of desired borrowing. Interest rates in general fall, asset prices rise. Investment, unlike savings, is interest-elastic, but not necessarily so interest-elastic that new borrowings and capital-raisings absorb new savings. Investment depends on firms' expectations of future revenue, which sets a limit to how much they will borrow/raise at _any_ interest rate/equity valuation.
Some asset-holders sacrifice liquidity/safety to maintain previous returns, so demand moves up the liquidity/risk spectrum. Clearly there's a tight limit to how far bond prices will rise, but the limit is much more flexible for shares, real estate and so on, especially once the expectation of capital gains kicks in. So, bubble. The difference between my story and yours, though, is that I don't see the bubble arising necessarily because a population with a given propensity to save suddenly goes crazy. The demand for financial assets might rise for a quite rational reason, say, because an ageing population wants to provide for its retirement.
> As a result, the people and firms who own these assets, participating in
> the illusion, feel incredibly wealthy and borrow enormous sums against their
> new wealth - sums that would have made them blanch if not for thee false
> comfort of their inflated asset portfolios. When the mania finally ends
> (also for psychological reasons, ultimately) the asset values collapse but
> the debts are still there, fixed in nominal terms. People and firms, shocked
> to find themselves with little or negative net worth, start behaving
> accordingly - they all try to save more, all at the same time. Hence,
> crisis.
>
> Where Fitch and Brenner go wrong is in supposing that the original run-up
> of financial asset prices must have been a sign that capitalists found real
> investment to be unprofitable. This idea is based on the assumption that a
> greater volume of speculative financial transactions must mean a lesser
> volume of real investment transactions. That's why I emphasized that
> financial assets are non-scarce. Their supply is limited not by any physical
> scarcity, but only by the state of people's expectations. Though you're
> right, the latter limit is real.
>
On these bits we totally agree. There's no necessity for real investment to become unprofitable before bubbles start.
Right, that's my three long posts for the day!
Cheers, Mike Beggs